Archives for April 2020

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Inherited HSA Rules

A reader writes in, asking:

“After last week’s article discussing the rules for inherited IRAs, I would be interested to hear about the rules for inherited HSA accounts. We have been using my HSA effectively as a ‘third retirement account’ contributing the max each year regardless of likely medical expenses, since we can take no-penalty distributions for any purpose after age 65. So there’s a good chance that the account will outlive me…or even both of us.”

This is an easy one.

There’s no such thing as an inherited HSA — at least not in the sense that there is with an inherited IRA (in which a beneficiary can continue to own the inherited IRA, with its own set of special rules, for many years).

That is, after you die:

  • If your spouse is the beneficiary of your HSA, the account just becomes his/her HSA. (That is, it’s not an “inherited HSA.” It’s just a normal HSA, now owned by your surviving spouse.)
  • If somebody other than your spouse is the beneficiary of your HSA, the account is no longer an HSA. It just becomes a regular taxable account, and the full value of the account is taxable as income to the beneficiary in the year of your death.*
  • If your estate is the beneficiary of your HSA, the account ceases to be an HSA, and the value of the account is included as income on your final tax return.

There are two primary financial planning implications here:

  1. If you’re married, name your spouse as the beneficiary of your HSA!
  2. It’s a good idea to prioritize spending down this account (to the extent of your qualified medical expenses, and potentially beyond that extent once you reach age 65) rather than retirement accounts, because your children (or other non-spouse heirs) would rather inherit a retirement account than an HSA that immediately becomes fully taxable.

*If your non-spouse beneficiary (other than your estate) pays for any of your qualified medical expenses within 1 year of the date of death, the amount of those expenses is subtracted from the amount that is taxable to beneficiary.

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Investing Blog Roundup: More Funds in 401(k) Leads to Better Outcomes

I hope you are all safe and as happy and healthy as it is possible for you to be.

For years, the conventional wisdom regarding 401(k) and other similar workplace retirement plans is that the plan shouldn’t have “too many” investment options. Having a lot of options causes employees to experience “choice overload,” which can lead to worse decisions.

I recently came across a piece of research from David Blanchett and Michael Finke (summary article below) that found exactly the opposite. Having a lot of choices causes more employees to accept the default investment option (possibly because of the feared choice overload). But these days (i.e., post-Pension Protection Act of 2006), that’s a good thing because more and more employers are using target-date funds as the default option.

Other Recommended Reading

Thanks for reading!

Inherited IRA Rules (Updated for 2020 to Reflect SECURE Act and CARES Act)

As a result of the SECURE Act that was passed in late 2019, there are now essentially two sets of rules for inherited IRAs. Which rules to use depends on a) when the original account owner died and b) who is listed as the beneficiary of the account.

Also, as a result of the CARES Act that was passed in March 2020, there are no required distributions for 2020 from IRAs — whether inherited or not.

Death in 2020 or Later

If the IRA owner dies in 2020 or later, we first have to determine whether the beneficiary is an “eligible beneficiary.”

Eligible beneficiaries include:

  • the surviving spouse of the original account owner,
  • a minor child of the original account owner,
  • anybody who is disabled or chronically-ill (per the definition found in IRC 7702B(c)(2)), or
  • any designated beneficiary who is not more than 10 years younger than the original account owner.

If the beneficiary is an eligible beneficiary, then the old rules apply (see below).

If the beneficiary is not an eligible beneficiary, the new rule applies. And the new rule simply says that the account must be completely distributed within 10 years of the original owner’s death. The distributions do not, however, have to occur evenly over those 10 years. (For instance, if you wanted to do so, you could take no distributions for the first 9 years, then distribute everything in year 10.)

Deaths in 2019 or Earlier, As Well as Eligible Beneficiaries

The “old rules” discussed in the remainder of this article apply in situations in which either:

  • The IRA owner died in 2019 or earlier, or
  • The beneficiary is an “eligible beneficiary” as described above, and therefore able to use the (more favorable) old rules.

Under the “old rules,” there are still actually two sets of rules: one set of rules that applies if the deceased owner was your spouse, and another set for any other designated beneficiary. We’ll cover spouse beneficiaries first, then non-spouse beneficiaries, then situations in which there are multiple beneficiaries.

Inherited IRA: Spouse Beneficiary

As a spouse beneficiary, you have two primary options:

  1. Do a spousal rollover — rolling the account into your own IRA, or
  2. Continue to own the account as a beneficiary.

Note: there’s no deadline on a spousal rollover. Should you want to, you can own the account as a spousal beneficiary for several years, then elect to do a spousal rollover.

If you do a spousal rollover, from that point forward it’s just a normal IRA (i.e., it’s just like any other IRA that was yours to begin with), so all the normal IRA rules apply, whether Roth or traditional.

If you continue to own the account as a spousal beneficiary, the rules will be similar to normal IRA rules, but with a few important exceptions.

No 10% Penalty
First, you can take distributions from the account without being subject to the 10% penalty, regardless of your age. So if you expect to need the money prior to age 59.5, this is a good reason not to go the spousal rollover route — at least not yet. (As mentioned above, there’s no deadline on a spousal rollover.)

Withdrawals from Inherited Roth IRA
Second, if the inherited account was a Roth IRA, any withdrawals of earnings taken prior to the point at which the original owner would have satisfied the 5-year rule will be subject to income tax (though not the 10% penalty).

Spouse Beneficiary RMDs
Third, you’ll have to start taking required minimum distributions (RMDs) in the year in which the deceased account owner would have been required to take them. (If the original owner — your spouse — was required to take an RMD in the year in which he/she died, but he/she had not yet taken it, you’re required to take it for him/her, calculated in the same way it would be if he/she were still alive.)

Your RMD from the account will be calculated each year based on your own remaining life expectancy from the “Single Life” table in IRS Publication 590-B.**

Inherited IRA: Non-Spouse Beneficiary

When you inherit an IRA as a non-spouse beneficiary, the account works much like a typical IRA, with three important exceptions.

No 10% Penalty
Distributions from the account are not subject to the 10% penalty, regardless of your age. (This is the same as for a spouse beneficiary.)

Withdrawals from Inherited Roth IRA
If the inherited account was a Roth IRA, any withdrawals of earnings taken prior to the point at which the original owner would have satisfied the 5-year rule will be subject to income tax, though not the 10% penalty. (This is also the same as for a spouse beneficiary.)

Non-Spouse Beneficiary RMDs
Each year, beginning in the year after the death of the account owner, you’ll have to take a required minimum distribution from the account. (If the account owner was required to take an RMD in the year of his death but he had not yet taken one, you’ll be required to take his RMD for him, calculated in the same way it would be if he were still alive.)

The rules for calculating your RMD are similar (but not quite identical) to the rules for a spousal beneficiary. Again, your first RMD from the account will be calculated based on your own remaining life expectancy from the “Single Life” table in IRS Publication 590-B. However, in following years, instead of looking up your remaining life expectancy again (as a spousal beneficiary would), you simply subtract 1 year from whatever your life expectancy was last year.**

For example, imagine that your father passed away in 2018 at age 65, leaving you his entire IRA. For 2018 (the year of death), you have no RMD. On your birthday in 2019, you turn 30 years old. According to the Single Life table, your remaining life expectancy at age 30 is 53.3 years. As a result, your RMD for 2019 would have been equal to the account balance as of 12/31/2018, divided by 53.3.

For 2020, if it weren’t for the CARES Act eliminating RMDs for 2020, your RMD would have been equal to the account balance at the end of 2019, divided by 52.3. (But because of the CARES Act, the RMD for 2020 would be zero.) In 2021, the RMD will be the 12/31/2020 balance, divided by 51.3.

Important exception: if you want, you can elect to distribute the account over 5 years rather than over your remaining life expectancy. If you elect to do that, you can take the distributions however you’d like over those five years — for example, no distributions in years 1-3 and everything in year 4.

Successor Beneficiary RMDs
If the original non-spouse beneficiary dies before the account has been fully distributed, the new inheriting beneficiary is known as a successor beneficiary.

If the original account owner died in 2020 or later, the new rule is that the successor beneficiary (regardless of who it is) will have to distribute the remainder of the account within 10 years of the death of the original beneficiary. (Note: within 10 years of the death of the original beneficiary, not 10 years of the death of the original owner.)

If the original account owner died in 2019 or prior, successor beneficiaries are subject to the same “old rules” as described above for the original beneficiary, with one exception: the successor beneficiary must continue to take distributions each year as if they were the original beneficiary.

By way of illustration, in the example above (with your father, the original owner, dying in 2018) if you were to then die in 2021, leaving the entire IRA to your sister, she would be required to continue taking RMDs from the account according to the exact same schedule you had been taking them, regardless of her own age. So if you hadn’t yet taken your 2021 distribution, she’d have to take it. Her 2022 distribution would be exactly what yours would have been if you were still alive: the 12/31/2021 balance, divided by 50.3.

Tips for Non-Spouse Beneficiaries

  1. When you retitle the account, be sure to include both your name and the name of the original owner.
  2. Name new beneficiaries for the account ASAP.
  3. If you decide to move the account to another custodian (to Vanguard from Edward Jones, for instance), do a direct transfer only. If you attempt to execute a regular rollover and you end up in possession of the funds, it will count as if you’d distributed the entire account.

Inherited IRA: Multiple Beneficiaries

If multiple beneficiaries inherit an IRA, they’re each treated as if they were non-spouse beneficiaries, and they each have to use the life expectancy of the oldest beneficiary when calculating RMDs. This is not a good thing, as it means less ability to “stretch” the IRA.

However, if the beneficiaries split the IRA into separate inherited IRAs by the end of the year following the year of the original owner’s death, then each beneficiary gets to treat his own inherited portion as if he were the sole beneficiary of an IRA of that size. This is a good thing, because it means that:

  • A spouse beneficiary will be treated as a spouse beneficiary rather than as a non-spouse beneficiary (thereby allowing for more distribution options), and
  • Each non-spouse beneficiary will get to use his or her own life expectancy for calculating RMDs.

Note: if the original owner dies in 2020 or later and at least one beneficiary is a “non-eligible beneficiary” (per the definition from the beginning in this article), then the whole account will have to be distributed within 10 years, unless the IRA agreement has a provision that immediately divides the IRA into separate IRAs for each beneficiary.

To split an inherited IRA into separate inherited IRAs:

  1. Create a separate account for each beneficiary, titled to include both the name of the deceased owner as well as the beneficiary.
  2. Use direct, trustee-to-trustee transfers to move the assets from the original IRA to each of the separate inherited IRA accounts.
  3. Change the SSN on each account to be that of the applicable beneficiary.

A Few Last Words

When you inherit an IRA, you absolutely must take the time to learn the applicable rules before you do anything. Don’t move the money at all until you understand what’s going on, because simple administrative mistakes can be very costly.

Also, should you elect to get help with the decision — a good idea, in my opinion — don’t assume that somebody knows the specifics of inherited IRA rules just because he or she is a financial advisor. In these circumstances, I’d suggest looking for someone with CPA or CFP certification.

**If a) the inherited IRA is a traditional IRA, b) you are older than the deceased IRA owner, and c) the deceased IRA owner had reached his “required beginning date” by the time he died, your RMD could actually be smaller than the amount calculated above, as you can calculate it based on what would be the deceased owner’s remaining life expectancy (from the “Single Life” table) using the owner’s age as of his birthday in the year of death (and reducing by one for each following year).

Investing Blog Roundup: Analyzing the CARES Act

I hope you have managed to stay healthy so far.

In the world of financial planning this week, the two biggest pieces of news are of course an enormous number of new unemployment claims and the new bailout package (the CARES Act). Jeffrey Levine has done an excellent job providing a brief overview of the various financial planning provisions of the CARES Act:

Other Recommended Reading

As always, thank you for reading.

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